by Archie M. Richards, Jr., CFP^®
March 17, 2003

If you own a taxable bond outside of a retirement plan, you can elect a tax method that will save you money. The method is applicable after interest rates have fallen, which they certainly have done.

To make the tax election clear, I first illustrate how bonds work in general:

Let's say that 8 years ago, a new 20-year bond of $10,000 was sold to the public. The interest rate on 20-year bonds at the time was 9 percent. The annual interest payments on the bond are therefore $900. (Interest payments on bonds always remain level. It's only the interest rates that vary, because the prices of bonds fluctuate as they're bought and sold among investors.)

Eight years have passed. The bond now matures in 12 years. During the 8-year interim, interest rates on long-term bonds have declined from 9 percent to 6 percent. New $10,000 bonds of 12 years maturity now being sold to the public pay only $600 a year.

You want to buy the older bond. It pays $900 a year when new $10,000 bonds pay only $600 a year. What does the older bond cost?

It costs you $12,540.

For 12 years until maturity, you receive interest payments of $900 a year. (Actually, you receive $450 twice a year, but this we'll disregard.)

You bought the bond for $12,540. At maturity, it pays off at $10,000. The loss of $2,540 reduces the overall "yield to maturity" from 9 percent to 6 percent.

If you don't elect the special treatment, your tax situation would be unfavorable. The $900 annual interest payments are taxable each year at the same high tax rate that applies to your salary.

But the $2,540 loss you can't use to reduce your taxes until the bond matures or is sold. Moreover, the loss is deductible only against capital gains income, which is taxed at the low rate of only 20 percent.

In other words, the $900 interest is taxed every year at high tax rates, but the $2,540 capital loss is deductible much later against low tax rates. Both results are unfavorable. Worse yet, if you die in the interim, the capital loss deduction is lost forever.

Feeling your pain, the IRS offers a better alternative, as follows:

1. Each year, you exclude a portion of the $900 interest from taxation. This reduces the interest income taxable at high ordinary-income tax rates.

2. Each year, you reduce the bond's cost basis by the same amount. During the 12 years to maturity, the $2,540 loss is gradually reduced, offsetting taxable interest all along the way.

In the first year, the reduction is $148, cutting your taxable interest income from $900 to $752.

The tax cost of the bond is reduced by the same $148, cutting the first year tax basis from $12,540 to $12,392.

Over the remaining life of the bond, the cost basis gradually falls to $10,000. At maturity, the bond pays off at $10,000, resulting in neither gain nor loss.

Here's the formula for determining each year's reduction of taxable income:

Last year's cost, multiplied by the yield to maturity, is subtracted from the current year's interest.

For the first year, the numbers are: $900 - ($12,540 x 6 percent) = $148. The cost basis declines every year, but the yield to maturity remains constant.

This tax-saving method is called "bond premium amortization." It's described in IRS Publication 550, which you'll find in www.irs.gov > Forms and Publications. No doubt your accountant is familiar with the method. Tax preparation programs are also prepared to handle it.

If you own individual taxable bonds, elect bond premium amortization. With interest rates having fallen so far, it could take a bite out of your tax burden.